No, it’s not all Kudrin all the time here at SWP. I know there are those of you looking for your clearing fix.
A brief thought about an unintended destination on the Road to SEFdom–a vertical silo.
Long time readers will know that my transactions cost economics-based analysis predicts that dominant execution venues will vertically integrate into of post-trade services, including clearing and settlement. Many dominant markets are already “silos” and others are moving in that direction. The days of an execution venue obtaining post-trade services from a “horizontal” CCP or settlement provider (like LCH.Clearnet) are numbered except when regulation (like RegNMS) socializes order flow.
Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue. Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies). No execution venue, no back-to-back monopoly problem.
That’s where the SEF mandate comes in. By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)
Whether this outcome occurs depends on the rules for SEFs. There is likely to be a proliferation of SEFs early on, but rules for SEFs will determine whether a handful or one survive for a particular instrument class. If SEF regulations (a) require them to operate auctions (rather than, say, RFQs), and (b) do not impose obligations on SEFs to direct orders to other SEFs offering better prices, then network effects will lead to tipping to a single venue. Conversely, if there are SEF order handling rules analogous to RegNMS, multiple SEFs may survive. Under the first alternative, integration is likely to occur. Under the second, the likely outcome is for multiple SEFs to be served by one horizontal CCP.
SEF rules are still up in the air, and I have not seen any discussion of inter-SEF obligations–or lack thereof. In contrast to SEC, CFTC has no tradition of even contemplating, let alone imposing, order handling rules. The issue has never really come up. I think the presumption in the agency is there will be rigorous competition among SEFs, but that conclusion depends crucially on SEF rules. In particular, rules relating to the way SEFs compete. If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF. This will lead to integration. If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.
Has anybody thought this through? Are order handling rules even on the table?